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Paper CMMU - Pair Trading from Threshold Cointegration

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Paper CMMU - Pair Trading from Threshold Cointegration

  1. 1. www.set.or.th/setresearch Disclaimer: The views expressed in this working paper are those of the author(s) and do not necessarily represent the Capital Market Research Institute or the Stock Exchange of Thailand. Capital Market Research Institute Scholarship Papers are research in progress by the author(s) and are published to elicit comments and stimulate discussion. Scholarship Project Paper 2015 Statistical Arbitrage in SET and TFEX : Pair Trading Strategy from Threshold Co-integration Model Surasak Choedpasuporn College of Management, Mahidol University 20 February 2015 Abstract In this study, we propose a variation of the statistical arbitrage trading strategy, “TVECM pair trading strategy”, which minimizes risk from its market neutral property and remains its profitability. To study performance of the strategy, we examine the 5-minutes intraday price relationship between pairs of assets in Thailand’s Stock Spot (SET) and Futures (TFEX) Markets and conduct backtesting. Three pairs of series of the same underlying asset (SET50, KTB, TRUE) which trade between 2nd July, 2014 and 29th August, 2014 are studied. Considering the differences of investor behaviors in different market condition, different level of mispricing spread and existence of the transaction cost in practical trading, the price relationship is estimated following the Threshold Vector Error Correction Model (TVECM). The TVECM pair trading strategy applies the estimated parameters to create trading signals. Applying the formulated strategy, the arbitrage opportunities are found. The performance of the TVECM pair trading strategy is found to be superior to the traditional pair trading strategy. JEL Classification: C22 Time-Series Models Keywords: Threshold Co-integration, Statistical Arbitrage, Pair Trading, Spot and Future E-Mail Address: surasak.cho@gmail.com
  2. 2. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Content Page Chapter 1 Introduction 1 1.1 Research Objective 4 1.2 Expected outcomes 5 Chapter 2 Literature Review 6 2.1 Theories 6 2.2 Empirical Research 8 Chapter 3 Research Methodology 10 3.1 Unit Roots 10 3.2 Co-integration & Error Correction Model 10 3.3 Threshold Vector Error Correction Model 12 3.4 Trading rule for pair trading strategy 13 3.5 Performance measurement of trading strategy 15 Chapter 4 Data 17 4.1 Data and pair selection criteria 17 4.2 Data and pair selection result 17 Chapter 5 Empirical Result 19 5.1 Unit root test and long-run relationship estimation 19 5.2 Short-run dynamic estimation 23 5.3 Threshold Vector Error Correction Model Estimation 25 5.4 Time rolling test 28 Chapter 6 Conclusion 33 References 35
  3. 3. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Content (cont.) Page Table 1. Adjustment processes in each regime of mispricing 3 2. Mispricing Spread of S50U14 and S50Z14 at 5-min frequency 3 3. Prices of S50M14 and S50U14 (Futures of SET50 Index). 4 4. Demonstration of the pair trading strategy 8 5. Illustration of Grid Search 13 6. Demonstration of TVECM pair trading rule proposed by Songyoo (2013) 14 7. Demonstration of Adjusted TVECM pair trading rule 14 8. Demonstration of time-rolling procedure 15 9. Plot of log S50U14 price series and its first difference 20 10. Plot of log S50Z14 price series and its first difference 20 11. Plot of cointegrating residuals of both series 20 12. Plot of log KTB price series and its first difference 21 13. Plot of log KTBU14 price series and its first difference 21 14. Plot of cointegrating residuals of both series 21 15. Plot of log TRUE price series and its first difference 22 16. Plot of log TRUEU14 price series and its first difference 22 17. Plot of cointegrating residuals of both series 23
  4. 4. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Content (cont.) Page Figure 1. Transaction cost of trading for proprietary trade 16 2. ADF Test result of lnS50U14 and lnS50Z14 series 19 3. ADF Test result of lnKTB and lnKTBU14 series 21 4. ADF Test result of lnTRUE and lnTRUEU14 series 22 5. SBIC Criteria of each no. of lags 23 6. Result of VECM for pair of log S50U14 and log S50Z14 at lags = 4 23 7. SBIC Criteria of each no. of lags 24 8. Result of VECM for pair of log KTB and log KTBU14 at lags = 2 24 9. SBIC Criteria of each no. of lags 25 10. Result of VECM for pair of log TRUE and log TRUEU14 at lags = 2 25 11. SBIC criteria for each no. of lags for pair of log S50U14 and log S50Z14 26 12. TVECM result under Three-regime for pair of log S50U14 and log S50Z14 26 13. SBIC criteria for each no. of lags for pair of log KTB and log KTBU14 27 14. TVECM result under Three-regime for pair of log KTB and log KTBU14 27 15. SBIC criteria for each no. of lags for pair of log TRUE and log TRUEU14 28 16. TVECM result under Three-regime for pair of log TRUE and log TRUEU14 28 17. Hansen-Seo test result 29 18. Performance result of each trading rule 30 19. Result of each trading rule with different training and execute period 31
  5. 5. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 1 Introduction Equity Investments is considered as a high risky activity. The research of Nestorovski and Naumoski (2013) found that the volatility of the economy and the risk of equity investing are correlated in the same direction. Current economic conditions in Thailand and global economic conditions fluctuate. In particular, some countries in the European Union, experiencing no ability to repay debt. Including the United States, which has debt problems as well. As a result, global economy fluctuate and dynamic without a clear direction. In Thailand, apart from global economic factors, domestic factors such as natural disasters and political instability also affect the volatility of the Thai Economy. According to the earlier statement of Nestorovski et al.(2013) , this situation will lead to the risk of investing in equities in the end. Thus, under the present circumstances, the risk management of investment is very important to investors. The Stock Exchange of Thailand as a regulator and promoter of investment in the Thailand’s Stock Market, has initiated a market in derivatives, called Thailand Futures Exchange (TFEX), in the year 2006 with many important objectives. One of the objectives is to provide investors a tool for efficient risk management such as Futures and Options. Aside from risk management, investors may use derivatives in many way. One approach to take advantage of derivatives in both risk management and profit speculation is Pair Trading Strategy. In some countries, Pair Trading Strategy is widely used, especially in fund equity risk (Hedge Fund) (Caldeira & Moura, 2012). Pair Trading Strategy (a.k.a Market Neutral Strategy) is a possible way that investors can expect high returns with low risk. The strategy minimizes
  6. 6. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 2 risk by elminating market risk from the portfolio (zero beta with the market). Another strength of Pair Trading is to eliminate feelings, judgment and ability of investor out of investing decision making, then replace them with a clear principle. (Gatev, Goetzman, Rouwenhorst, 2006). Principles of Pair Trading strategy is to invest in two assets, which the prices can be expected to closely related, at the same time. When prices of the pair diverge, open a Short Position in a higher priced asset, and simultaneously open a Long Position in the lower priced asset with equal value. Over time, the prices will converge, then close all Positions. The difference in price at open and close positions will become profit (Vidyamurthy, 2004). Pair Trading Strategy can be applied to many types of assets, including stocks, derivatives and commodity products. Key success factors of strategy implementation are pair selection and position timing. The term ‘Statistical Arbitrage Strategy’ consists of 3 features are: (1) trading signals are systematic or rule-based, (2) the portfolio has zero beta with the market, and (3) the investing mechanism is statistical (Avellaneda & Lee, 2009). To effectively execute pair trading strategy, we should estabilsh an organized mechanism following concept of the statistical arbitrage strategy. Vidyamurthy (2004) proposed a way for pair selection by using the concept of Cointegration. The Cointegration is a process of time series, which is introduced by Granger (1981) as a tool to analyze the relationships of couples in long-term. If the prices of pair are found to have a Cointegration relationship, they will have a long-run relationship and have mean reversion property of their mispricing spread. In short-run, the relationship is analyzed using Error Correction Model (a.k.a. ECM) (Enger & Granger, 1987). In reality, with existence of the transaction cost such as commission cost, the ECM might not be suitable to describe the relationship of the pair. There is an extend model, Threshold Vector Error Correction Model (a.k.a. TVECM), which is considered a difference of
  7. 7. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 3 adjustment process in different regimes. Figure 1 shows adjustment processes of three regime which separate mispricing spread into 3 ranges (regimes) divisioning by 2 threshold lines. The speeds (slope) of adjustment of the three regimes do not equal. In case of speed of adjustment equal zero, we call this regime a ‘No arbitrage band’. This case can occur if the mispricing amount does not cover transaction cost, then the investor hold position and do not trade. Figure 1 : Adjustment processes in each regime of mispricing We preliminarily examined mispricing spread of S50U14 and S50Z14 at 5-minute frequency, we notice some range of mispricing spread that the mispricing does not change as Figure 2. This might be a sign of ‘No arbitrage band’. Figure 2 : Mispricing Spread of S50U14 and S50Z14 at 5-min frequency
  8. 8. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 4 The TVECM can also be applied to generate trading signal for position timing in Pair Trading Strategy (Songyoo, 2013). The previous study of Songyoo (2013) focused in pair of Spot and its Future. This paper aims to study further of the TVECM pair trading strategy in broader dimension and also aims to improve the TVECM pair trading stretegy. Figure 3 shows intraday prices of S50M14 and S50U14 which share the same underlying asset of SET50 Index. The illustration shows that their prices are highly correlated. The author considers this type of pair might be found the arbitrage opportunity as well. Our study will study on this type of pair. The performance of the TVECM pair trading strategy is measured and compared to the performance of traditional pair trading strategy. Figure 3 : Prices of S50M14 and S50U14 (Futures of SET50 Index). Source : Data from eFin Smart Portal by www.efinancethai.com 1.1 Research Objective : 1. To examine price relationship between a future and its underlying asset and another series of future from the same underlying asset 2. To improve trading performance of pair trading strategy by applying Threshold Co-integration Model (TVECM) 3. To evaluate performance of pair trading strategies in Thailand Spot & Future Markets
  9. 9. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 5 1.2 Expected outcomes 1. Understanding of the price relationship of a future and its underlying asset and another series of future from the same underlying asset 2. A new pair trading strategy which outperforms the traditional pair trading strategy 3. Performance of pair trading strategies in Thailand Spot & Future Markets
  10. 10. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 2 Literature Review 2.1 Theories 2.1.1 Efficient Market Hypothesis & Cost of Carry Model Efficient Market Hypothesis (EMH) was presented by Fama (1965). Fama explained that the capital market is efficient or the current price is already reflected by the stock information related to them. Therefore, the current price is a reasonable price. Fama (1970) has further divided the Market into three forms. 2.1.1.1 Weak Form is considered that the current price already reflected by the price information in the past. But the investors can utilize public information, and insider information to make an abnormal profit. 2.1.1.2 Semi-strong Form is considered that the current price already reflected by the past price and public information. Only investors with insider information can make an abnormal profit. 2.1.1.3 Strong Form is considered that the current price already reflected by the past price, public and insider information. No one can make an abnormal profit. We can conclude that in any form of market, the past price cannot be used to make an abnormal profit. Additional, if the market is fully efficient, all economic agent will have the same information. Then, the future price at time (t) should be expected to equal the spot price at the maturity date (T) of the future contract. Considering the cost of carrying model into this situation, the future
  11. 11. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 7 price will be expected to equal to the spot price plus its carrying cost through time until the maturity date. ft,T = Et(ST) = St(the cost of carrying asset over time) If that is the case, the gap between future price and spot price should be constant and there is no arbitrage opportunity. But if the market is not fully efficient, the gap will not be constant and there is an arbitrage opportunity (Songyoo, 2013). 2.1.2 Mispricing, Arbitrage Opportunity & Pair Trading If the market is not fully efficient and the gap between the future price and spot price is not constant, there will be a chance that the future price does not equal to the spot price plus its carrying cost or they are mispricing. For example, the future price ft,Tis higher than the spot price plus carrying cost. ft,T - St(the cost of carrying asset over time) > 0 In this scenario, there will be an arbitrage opportunity to short sell the expensive one (ft,T) and buy the cheap one (St). The selling force will lower the price of the expensive one, whereas the buying force will increase the price of the cheap one. As a result, the difference between both prices will be diminished until it disappears (Songyoo, 2013). The Pair Trading Strategy comes into play when the investors found the existence of an arbitrage opportunity. As we known that the future price and the spot price will move together but they might diverge in some chances. As shown in Figure 4, opening of ‘Short Selling’ position in the expensive one, and in the
  12. 12. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 8 same time opening of ‘Long Buying’ position in the cheap one, then hold the positions until the prices converge, will create a profit with a minimal risk (Vidyamurthy, 2004). To explain more how the risk is minimized, we can start with general idea of systematic risk and unsystematic risk. Investing in any asset consist of these 2 risks. For holding short and long positions of a pair of asset that share the same fundamental or same underlying asset, both systematic risk and unsystematic risk will be canceled out. The remaining risk is occurred from mispricing which is expected to have a mean reversion behavior. To deal with this risk, we need to understand the mispricing behavior which will be discussed in Chapter 3 Research Methodology. Figure 4 : Demonstration of the pair trading strategy 2.2 Empirical Research Thongthip (2010) applied Threshold Autoregressive Model (TAR) along with cost of carry model to explain the lead-lag and long-run relationship between SET50 Index and its future which were traded between October 2008 to September 2009. The result shows that the prices of pair move together and confirm that long-run relationship exists between both market. Anyway, lead-lag relationship does not found in daily data, but it found at intraday data of 5-
  13. 13. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 9 minute data. Kaewmongkolsri (2011) studied KTB and its future which were traded between July to December 2010 with Vector Error Correction Model and found long-run and short-run relationship. Intraday price data is recommended to use for study, since the relationship do not last for more than half an hour. This study also confirms long-run relationship of pair prices at 10-minute data. Songyoo (2013) also applied the Threshold Cointegration (TVECM) to explain the relationship between spot and future market. This study also confirms that long- run relationship exists between two markets for SET50 Index, KTB equity and their futures at intraday 10-minute data. In this study, the author also formulated a pair trading strategy by applying estimated threshold as a trigger point for positioning signal. The simulated portfolio using price data traded between September - November 2011 can make a positive return and confirm the existence of an arbitrage opportunity.
  14. 14. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 3 Research Methodology 3.1 Unit Roots The stationary property of the data is one of primary factors to be studied. The data with a stationary process will have a steady state of mean and variance as time passes. In the other hand, if the process is non- stationary, the process is said to has a unit root. A common way to test a unit root is performing Augmented Dickey-Fuller Test (a.k.a. ADF Test) (Dickey & Fuller, 1981). The ADF Test can be performed by using the following equation. ∆𝑥𝑡 = 𝜇1 + 𝛾𝑥𝑡−1 + 𝜇2 𝑡 + ∑ 𝛽𝑖∆ ∞ 𝑖=1 𝑥𝑡−𝑖 + 𝜀𝑡 Where 𝑥𝑡 represents the series of data to be tested a unit root. For this study, 𝑥𝑡 is a series of log futures price or log spot price. The test hypothesis is H0 : = 0 and Ha : <> 0.If the null hypothesis is rejected, the series is stationary and has no unit root. The order of integration is at level or I(0). If the null hypothesis is failed to be rejected, the series is non-stationary and has a unit root. In this case, we need to test the series at its first difference. If the series is stationary at its first difference, the series is said to has integration of order 1 or I(1). 3.2 Co-integration & Error Correction Model Granger (1981) has proposed a long-term relationship between the 2 variables by explaining that when 2 variables have the same Order of Integration, and found a linear combination of both variables that produces another variable which has a lower Order of Integration, then the 2 variables
  15. 15. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 11 are considered to have a long-term relationship or said to have a Cointegration property. However, when 2 variables are related in the long term, the two variables may deviate apart in the short term. To maintain the long- relationship, there must be a mechanism to adjust the deviation of the two variables to return to their long-term equilibrium. Such a mechanism has been proposed as the Error Correction Model (a.k.a. ECM) (Engle & Granger, 1987). For the Error Correction Model of CI(1,1) is formulated as the following model. ∆𝑥𝑡 = 𝛼0 + 𝛼 𝑥 𝑧𝑡−1 + ∑ 𝛼1𝑗∆𝑥𝑡−𝑗 + ∑ 𝛼2𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑥𝑡 ∆𝑦𝑡 = 𝑏0 + 𝑏 𝑦 𝑧𝑡−1 + ∑ 𝑏1𝑗∆𝑦𝑡−𝑗 + ∑ 𝑏2𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑦𝑡 Where 𝑧𝑡−1 = 𝑥𝑡−1 − 𝛽𝑦𝑡−1 𝑧𝑡−1 is called ‘Error Correction Term’ (a.k.a. ECT). The ECT is the adjusting part that maintains both variables to return or converge to their equilibrium. 𝛽 is the cointegration coefficient. Johansen (1991) has proposed a Maximum-Likelihood Estimation method to test the ECM as an extend version of Vector Autoregressive Model (VAR) called Vector Error Correction Model (VECM). The test follows this hypothesis. 𝐻0 ∶ 𝑟𝑎𝑛𝑘(𝛱) = 0 and 𝐻 𝑎 ∶ 𝑟𝑎𝑛𝑘(𝛱) ≠ 0 Where 𝛱 is the cointegration matrix. Using the Trace test or Maximum Eigenvalues test, if the null hypothesis is failed to be rejected, then there is no cointegration, if the null hypothesis is rejected, then there is cointegration.
  16. 16. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 12 3.3 Threshold Vector Error Correction Model Balke & Fomby (1997) have suggested the possibility that the relationship between the two variables may not adjust as a simple linear process or may not happen all the time, but it may occur when variables are deviations from equilibrium up to a certain point (Threshold value or γ). For example, economic agents may not take any action, if they expect their returns do not more than the costs occurred. If the adjustment process is following this feature, it will have a Threshold Cointegration property. We can consider Threshold Cointegration property to have many regimes or bands. Each regime will have its adjustment behavior of its own. For Three-regimes model, the equation is as follows, For regime 1, when (𝑥𝑡−1 − 𝛽𝑦𝑡−1) ≤ 𝛾𝑎 ∆𝑥𝑡 = 𝑎0 + 𝛼1𝑥 𝑧𝑡−1 + ∑ 𝑎11𝑗∆𝑥𝑡−𝑗 + ∑ 𝑎12𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑥𝑡 ∆𝑦𝑡 = 𝑏0 + 𝛼1𝑦 𝑧𝑡−1 + ∑ 𝑏11𝑗∆𝑥𝑡−𝑗 + ∑ 𝑏12𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑦𝑡 For regime 2, when 𝛾𝑎 < (𝑥𝑡−1 − 𝛽𝑦𝑡−1) ≤ 𝛾 𝑏 ∆𝑥𝑡 = 𝑎0 + 𝛼2𝑥 𝑧𝑡−1 + ∑ 𝑎21𝑗∆𝑥𝑡−𝑗 + ∑ 𝑎22𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑥𝑡 ∆𝑦𝑡 = 𝑏0 + 𝛼2𝑦 𝑧𝑡−1 + ∑ 𝑏21𝑗∆𝑥𝑡−𝑗 + ∑ 𝑏22𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑦𝑡 For regime 3, when 𝛾 𝑏 < (𝑥𝑡−1 − 𝛽𝑦𝑡−1) ∆𝑥𝑡 = 𝑎0 + 𝛼3𝑥 𝑧𝑡−1 + ∑ 𝑎31𝑗∆𝑥𝑡−𝑗 + ∑ 𝑎32𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑥𝑡 ∆𝑦𝑡 = 𝑏0 + 𝛼3𝑦 𝑧𝑡−1 + ∑ 𝑏31𝑗∆𝑥𝑡−𝑗 + ∑ 𝑏32𝑗∆𝑦𝑡−𝑗 + 𝜖 𝑦𝑡 Balke et. al (1997) presented a method to test the Threshold Cointegration as follows. The test is divided into two steps. The first step is to test a Cointegration property of the Time-series. If the Cointegration exists, then test the next step by testing for a Threshold or Nonlinear property of the Time-series. However, this guideline is available only when we know
  17. 17. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 13 the Cointegration Vector (β). For this reason, Hansen & Seo (2002) have proposed a MLE method using the Grid Search method illustrated as Figure 5. This method will generate all possible pairs of the β (Cointegrating Vector) and γ (Threshold value) within a scope and constraints, then test every pair to find the optimal β (Cointegrating Vector) and γ (Threshold value) by using the AIC and SBIC selection criteria. In addition, Hansen et. al (2002) also proposed the SupLM Test called ‘Hansen-Seo test’ to test the null hypothesis of linear cointegration (no threshold behavior) versus the alternative hypothesis of threshold cointegration. Figure 5 : Illustration of Grid Search 3.4 Trading rule for pair trading strategy From the TVECM, we known that the adjustment process will separated into many regimes. The regimes will be decided from the threshold values. Applying this concept into Pair Trading Strategy, we can use the threshold values and regimes as a signaling tool. From the study of Songyoo (2013), we found that using 3-regimes TVECM, most of observation was found to fall into the Regime 2. This regime is also called “No-arbitrage band”. If the observation fall into Regime 1 or Regime 3, the gap of mispricing will strong enough to gain a profit. The previous study suggested a pair trading rule as these steps. At first, open Long/Short positions when the observation is out of Regime 2. Then, if observation returns to the Regime 2, close the positions. The trading rule is illustrated as Figure 6.
  18. 18. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 14 Figure 6 : Demonstration of TVECM pair trading rule proposed by Songyoo (2013) Since the transaction cost is considered to highly affect the performance of trading rule, we adjusts the trading rule to reduce trading over minor gap of mispricing by skipping of position closing when the observation returns to the Regime 2, and instead, close the position only when observation shifts across regime 1 to regime 3 or the opposite way. The adjusted trading rule is illustrated as Figure 7. Figure 7 : Demonstration of Adjusted TVECM pair trading rule
  19. 19. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 15 3.5 Performance measurement of trading strategy To be realistic, we perform the out-sample test by applying time- rolling in our measurement. The time-rolling procedure is described as following. First, setting initial training periods to estimate the parameters. This study set the initial period as 600 periods or 10 trading days. Second, execute trading rule by using the estimated parameters for next periods. This study uses these parameters for 300 periods or 5 trading days. Third, after end of rule execution period from second step, move the training period forward same length as the execution period and repeat first and second steps until end of data. The time-rolling procedure is illustrated as Figure 8. Figure 8 : Demonstration of time-rolling procedure To calculate net profit, we consider using transaction cost of proprietary trade. The transaction cost is described as Table 1. Apply these transaction cost rate, we can calculate net profit as the performance of the trading strategy. Aside from absolute return from the net profit, we compare the performance with the traditional pair trading strategy. The traditional pair trading strategy applied moving averages and standard deviations as triggering signal. The position opening will occur when the observation deviates from the moving average more than 2 times of standard deviations. The position closing will occur when the observation converges.
  20. 20. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 16 Table 1 : Transaction cost of trading for proprietary trade Asset type Transaction Fee Trading size Stock 0.0015 x 0.07 x [stock price] (equals to VAT of commission cost) Multiplying of 100 units SET50 Future 7 THB per contract 200 units per contract Stock Future 35 THB per contract 1,000 units per contract
  21. 21. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 4 Data 4.1 Data and pair selection criteria Our research aims to study the long-run equilibrium relationship and the short-run dynamic between the prices of assets sharing the same underlying asset. The pair of asset with a long-run relation will be studied its potential for the arbitrage opportunities from the deviation of two prices. Our focus is the assets that are traded in Thailand Stock Spot (SET) and Futures (TFEX) markets. The data used in the study are obtained from the eFin Smart Portal software provided by www.efinancethai.com on 28th September, 2014. To prevent a no-trading price bias, a criteria based on liquidity of series will be a counter-measure. The selected series will be ones with less than 10% of missing volume trade. Previous research suggested to use price data that higher frequency than half an hour (Kaewmongkolsri, 2011). A recent study of Songyoo (2013) found that optimal frequency was 10-minute for that period. Anyway, we found that 5-minute frequency is more suitable for this research because the current liquidity is more than previous research. In this research, the pair is formed by 2 types of series. For type 1, the pair is formed by a spot and its future. For type 2, the pair is formed by two futures from different contract months of the same underlying asset. 4.2 Data and pair selection result The pairs of assets are selected under the criteria. Trading period ranges from 2nd July 2014 to 29 August 2014 including 40 trading days. At 5-minute price data, there are 2,439
  22. 22. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 18 observations. Anyway, we found that the liquidity of most Stock Futures are very low, as a result there are 3 pairs selected under the criteria. The selected pairs are as following. 1)S50U14 (SET50 Index Futures September 2014 Contract) and S50Z14 (SET50 Index Futures December 2014 Contract) 2)KTB and KTBU14 (KTB Futures September 2014 Contract) 3)TRUE and TRUEU14 (TRUE Futures September 2014 Contract)
  23. 23. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 5 Empirical Result 5.1 Unit root test and long-run relationship estimation Before examining the long-run relationship of each pairs, order of integration of each series and their cointegration residuals should be assessed. To assess the order of integrations, the unit root test will be performed by applying Augmented Dickey Fuller Test (ADF). Table 2 summarizes the result of ADF Test of log of S50U14 price series and log of S50Z14 price series. Both log of S50U14 price series and log of S50Z14 price series are I(1) as illustrated in Figure 9 and Figure 10. The cointegration residuals of both series is I(0) or log of S50U14 price series and log of S50Z14 price series is cointegrated of order (1,1) as illustrated in Figure 11. The cointegrating equation of the long-run relationship for log of S50U14 price series and log of S50Z14 price series is as following equation. lnS50U14 – 0. 9731*lnS50Z14 - 0.1835 = residuals Table 2 : ADF Test result of lnS50U14 and lnS50Z14 series Price Series ADF Statistics Critical Value (5% conf) Conclusion ln S50U14 1.2074 -1.95 Non-stationary First Diff of ln S50U14 -14.9476 -1.95 Stationary ln S50Z14 1.3428 -1.95 Non-stationary First Diff of ln S50Z14 -14.8831 -1.95 Stationary Cointegration Residuals -2.901 -1.95 Stationary
  24. 24. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 20 Figure 9 : Plot of log S50U14 price series and its first difference Figure 10 : Plot of log S50Z14 price series and its first difference Figure 11 : Plot of cointegrating residuals of both series Table 3 summarizes the result of ADF Test of log of KTB price series and log of KTBU14 price series. Both log of KTB price series and log of KTBU14 price series are I(1) as illustrated in Figure 12 and Figure 13. The cointegration residuals of both series is I(0) or log of KTB price series and log of KTBU14 price series is cointegrated of order (1,1) as illustrated in Figure 14. The cointegrating equation of the long-run relationship for log of KTB price series and log of KTBU14 price series is as following equation. lnKTB – 0.9732*lnKTBU14 - 0.0798 = residuals
  25. 25. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 21 Table 3 : ADF Test result of lnKTB and lnKTBU14 series Price Series ADF Statistics Critical Value (5% conf) Conclusion ln KTB 1.2048 -1.95 Non-stationary First Diff of ln KTB -16.8014 -1.95 Stationary ln KTBU14 1.1618 -1.95 Non-stationary First Diff of ln KTBU14 -15.7308 -1.95 Stationary Cointegration Residuals -5.1521 -1.95 Stationary Figure 12 : Plot of log KTB price series and its first difference Figure 13 : Plot of log KTBU14 price series and its first difference Figure 14 : Plot of cointegrating residuals of both series
  26. 26. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 22 Table 4 summarizes the result of ADF Test of log of TRUE price series and log of TRUEU14 price series. Both log of TRUE price series and log of TRUEU14 price series are I(1) as illustrated in Figure 15 and Figure 16. The cointegration residuals of both series is I(0) or log of TRUE price series and log of TRUEU14 price series is cointegrated of order (1,1) as illustrated in Figure 17. The cointegrating equation of the long-run relationship for log of TRUE price series and log of TRUEU14 price series is as following equation. lnTRUE – 1.0133 * lnTRUEU14 + 0.03115 = residuals Table 4 : ADF Test result of lnTRUE and lnTRUEU14 series Price Series ADF Statistics Critical Value (5% conf) Conclusion ln TRUE 1.2871 -1.95 Non-stationary First Diff of ln TRUE -14.5677 -1.95 Stationary ln TRUEU14 1.3269 -1.95 Non-stationary First Diff of ln TRUEU14 -13.7488 -1.95 Stationary Cointegration Residuals -4.6128 -1.95 Stationary Figure 15 : Plot of log TRUE price series and its first difference Figure 16 : Plot of log TRUEU14 price series and its first difference
  27. 27. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 23 Figure 17 : Plot of cointegrating residuals of both series 5.2 Short-run dynamic estimation To estimate short-run dynamic of pairs, we apply Johansen’s MLE for Vector Error Correction Model (VECM). For pair of log S50U14 and log S50Z14, the optimal lags is selected by SBIC criteria as shown in Table 5 and the result of estimation shows as Table 6. Table 5 : SBIC Criteria of each no. of lags No. of Lags SBIC Criteria 1 -75347.99 2 -75450.98 3 -75509.91 4* -75511.85 5 -75498.51 Optimal No. of Lags = 4 Table 6 : Result of VECM for pair of log S50U14 and log S50Z14 at lags = 4 ∆𝒍𝒏𝑺𝟓𝟎𝑼𝟏𝟒 Coefficients Standard Error Correction Term -0.0097 0.0207 ∆𝒍𝒏𝑺𝟓𝟎𝒁𝟏𝟒 Coefficients Standard Error Correction Term 0.0350 0.0204
  28. 28. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 24 The error correction term is yt-1 – 0. 9731xt-1 - 0.1835. For VECM, the coefficients of error correction term represent speed of adjustment. For this pair, speed of adjust of log S50U14 is 0.0097 with negative sign and speed of adjust of log S50Z14 is 0.0350 with positive sign. Considering magnitude of the adjustment speed, we can estimate that the convergence process will take at least 100 periods for log S50U14 series and 30 periods for log S50Z14 series. Since the speed of adjustment is quite slow, it can be an effect of transaction cost that might lead to Threshold behavior in the adjustment process. For pair of log KTB and log KTBU14, the optimal lags is selected by SBIC criteria as shown in Table 7 and the result of estimation shows as Table 8. Table 7 : SBIC Criteria of each no. of lags No. of Lags SBIC Criteria 1 -60146.33 2* -60195.98 3 -60190.13 4 -60169.46 5 -60147.73 Optimal No. of Lags = 2 Table 8 : Result of VECM for pair of log KTB and log KTBU14 at lags = 2 ∆𝒍𝒏𝑲𝑻𝑩 Coefficients Standard Error Correction Term -0.1439 0.0181 ∆𝒍𝒏𝑲𝑻𝑩𝑼𝟏𝟒 Coefficients Standard Error Correction Term 0.0304 0.0119
  29. 29. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 25 For pair of log TRUE and log TRUEU14, the optimal lags is selected by SBIC criteria as shown in Table 9 and the result of estimation shows as Table 10. Table 9 : SBIC Criteria of each no. of lags No. of Lags SBIC Criteria 1 -52871.78 2* -52970.13 3 -52947.77 4 -52926.33 5 -52882.86 Optimal No. of Lags = 2 Table 10 : Result of VECM for pair of log TRUE and log TRUEU14 at lags = 2 ∆𝒍𝒏𝑻𝑹𝑼𝑬 Coefficients Standard Error Correction Term -0.0556 0.0137 ∆𝒍𝒏𝑻𝑹𝑼𝑬𝑼𝟏𝟒 Coefficients Standard Error Correction Term 0.0229 0.0096 5.3 Threshold Vector Error Correction Model Estimation After we found long-run relationship behavior of the pair, we can further analyze the relation to assess existing of Threshold behavior. Following steps describes in chapter 3, we can estimate TVECM model for the pair series. For pair of log S50U14 and log S50Z14, the optimal lags is selected by SBIC criteria as shown in Table 11 and the result of TVECM estimation under Three-regime is shown in Table 12.
  30. 30. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 26 Table 11 : SBIC criteria for each no. of lags for pair of log S50U14 and log S50Z14 No. of Lags SBIC Criteria 1 -75285.54 2* -75319.88 3 -75303.85 4 -75264.81 5 -75206.03 Optimal No. of Lags = 2 Table 12 : TVECM result under Three-regime for pair of log S50U14 and log S50Z14 Item Values Cointegrating Vector (1,-0.9995833) No. of Lags 2 Threshold Values -0.0004032538 -0.0001141731 No. of Observations 2,439 Upper Regime (78.45% of Obs) Coefficient ECT lnS50U14 = -0.010713508 Coefficient ECT lnS50Z14 = -0.003017899 Middle Regime (16.54% of Obs) Coefficient ECT lnS50U14 = -0.4226353 Coefficient ECT lnS50Z14 = -0.1566429 Lower Regime (5.01% of Obs) Coefficient ECT lnS50U14 = 0.1678026 Coefficient ECT lnS50Z14 = 0.7490027 For pair of log KTB and log KTBU14, the optimal lags is selected by SBIC criteria as shown in Table 13 and the result of TVECM estimation under Three-regime is shown in Table 14.
  31. 31. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 27 Table 13 : SBIC criteria for each no. of lags for pair of log KTB and log KTBU14 No. of Lags SBIC Criteria 1* -60069.65 2 -60053.86 3 -59988.43 4 -59893.8 5 -59816.43 Optimal No. of Lags = 1 Table 14 : TVECM result under Three-regime for pair of log KTB and log KTBU14 Item Values Cointegrating Vector (1,-0.9982666) No. of Lags 1 Threshold Values 0.003186499 0.004160424 No. of Observations 2,439 Upper Regime (24.66% of Obs) Coefficient ECT lnKTB = -0.3336562 Coefficient ECT lnKTBU14 = 0.1379370 Middle Regime (11.08% of Obs) Coefficient ECT lnKTB = 0.5694124 Coefficient ECT lnKTBU14 = 0.7640926 Lower Regime (64.26% of Obs) Coefficient ECT lnKTB = -0.09145585 Coefficient ECT lnKTBU14 = 0.01749865 For pair of log TRUE and log TRUEU14, the optimal lags is selected by SBIC criteria as shown in Table 15 and the result of TVECM estimation under Three-regime is shown in Table 16.
  32. 32. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 28 Table 15 : SBIC criteria for each no. of lags for pair of log TRUE and log TRUEU14 No. of Lags SBIC Criteria 1 -52829.88 2* -52871.50 3 -52796.82 4 -52730.27 5 -52674.12 Optimal No. of Lags = 2 Table 16 : TVECM result under Three-regime for pair of log TRUE and log TRUEU14 Item Values Cointegrating Vector (1,-1.001244) No. of Lags 2 Threshold Values -0.007136592 0.017959877 No. of Observations 2,439 Upper Regime (1.93% of Obs) Coefficient ECT lnTRUE = 0.2421379 Coefficient ECT lnTRUEU14 = 0.1656139 Middle Regime (59.32% of Obs) Coefficient ECT lnTRUE = -0.01867759 Coefficient ECT lnTRUEU14 = 0.01332959 Lower Regime (38.75% of Obs) Coefficient ECT lnTRUE = -0.19547302 Coefficient ECT lnTRUEU14 = 0.04773023 5.4 Time rolling test Performance of trading rule is measured by calculation of net profit from portfolio simulation. Out-sample performance or time-rolling procedure is used to make the portfolio simulation more realistic. The simulation uses trading period from 2nd July 2014 to 29th August 2014. The first time rolling will be set training period from 2nd July 2014 to 16th July 2014 which consists
  33. 33. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 29 of 10 trading days or 600 observations. The estimated parameters or threshold values will be used for next 5 trading days or 300 observations. The time- rolling is repeated using 5-day time rolling. 5.4.1 Hansen-Seo Test Before performing the portfolio simulation, we should test that whether the pairs have threshold behavior or not. As discussed in chapter 3, Hansen et. al (2002) proposed ‘Hansen-Seo test’ to test existence of the threshold behavior. We perform Hansen-Seo test for every time rolling of each pair. The result is shown in Table 17. Table 17 : Hansen-Seo test result Time Rolling P-Value Pair 1 S50U14-S50Z14 Pair 2 KTB-KTBU14 Pair 3 TRUE-TRUEU14 1) Training Period : 1-600 0.06 **0.00 **0.00 2) Training Period : 301-900 0.53 **0.00 **0.00 3) Training Period : 601-1200 N/A **0.00 **0.00 4) Training Period : 901-1500 0.10 0.42 **0.00 5) Training Period : 1201-1800 0.97 **0.00 **0.00 6) Training Period : 1501-2100 *0.03 0.17 **0.00 7) Training Period : 1801-2400 0.13 **0.00 *0.03 Note : * p-value < 0.05, **p-value < 0.01 Time rolling no. 3) of Pair 1 cannot be estimated any threshold parameter, in this case we skip this time-rolling. For overall result of the test, the result shows that in some time rollings, the null hypothesis of linear cointegration (no threshold behavior) cannot be rejected. Anyway, we still can use the estimated threshold parameters to use as signaling point in pair trading strategy.
  34. 34. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 30 5.4.2 Trading Rule Performance Measurement We simulate portfolio for each trading rule. The performance of each trading rule for each pair is shown in Table 18. Table 18 : Performance result of each trading rule Trading Rule Pair 1 (S50U14 - S50Z14) THB 200 / index point Pair 2 (KTB - KTBU14) 1,000 shares / contract Pair 3 (TRUE - TRUEU14) 1,000 shares / contract Trading Rule 1 (Original TVECM) No. of Transactions 132 192 160 Gross Profit 3,820 7660 6076 Transaction Cost 1,848 7182 5774 Net Profit *1,972 478 302 Trading Rule 2 (Adjusted TVECM) No. of Transactions 82 124 128 Gross Profit 2,940 5280 5585 Transaction Cost 1,148 4641 4620 Net Profit 1,792 *639 *965 Traditional Pair Trading No. of Transactions 36 40 46 Gross Profit 1,280 1,790 1,535 Transaction Cost 504 1,496 1,659 Net Profit 776 294 (-124) For pair 1 of S50U14 - S50Z14, the original TVECM pair trading strategy generates the best result of 1,972 THB of net profit for trading 1 contract at a time. For pair 2 of KTB - KTBU14, the adjusted TVECM pair trading strategy generates the best result of 639 THB of net profit for trading 1 contract at a time.
  35. 35. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 31 For pair 3 of TRUE - TRUEU14, the adjusted TVECM pair trading strategy generates the best result of 965 THB of net profit for trading 1 contract at a time. To study further, we shortened the length of training period and execute period which will make the pair trading rule response to price data faster. We adjusted starting time to make total execute periods equal to trading result above and let them comparable. In this part, the first time rolling will be set training period from 9th July 2014 to 16th July 2014 which consists of 5 trading days or 300 observations. The estimated parameters or threshold values will be used for next trading day or 60 observations. The time-rolling is repeated using 1-day time rolling. The performance of each trading rule for each pair is shown in Table 19. Table 19 : Result of each trading rule with different training and execute period Trading Rule Pair 1 (S50U14 - S50Z14) THB 200 / index point Pair 2 (KTB - KTBU14) 1,000 shares / contract Pair 3 (TRUE - TRUEU14) 1,000 shares / contract Training : 600 Execute : 300 Training : 300 Execute : 60 Training : 600 Execute : 300 Training : 300 Execute : 60 Training : 600 Execute : 300 Training : 300 Execute : 60 Trading Rule 1 (Original TVECM) No. of Transactions 132 152 192 226 160 196 Gross Profit 3,820 5,100 7660 9,890 6076 6,852 Transaction Cost 1,848 2,128 7182 8,453 5774 7,073 Net Profit *1,972 *2,972 478 1,437 302 (-221) Trading Rule 2 (Adjusted TVECM) No. of Transactions 82 86 124 178 128 136 Gross Profit 2,940 3,100 5280 8,750 5585 5,820 Transaction Cost 1,148 1,204 4641 6,658 4620 4,908 Net Profit 1,792 1,896 *639 *2,092 *965 *912
  36. 36. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 32 Trading Rule Pair 1 (S50U14 - S50Z14) THB 200 / index point Pair 2 (KTB - KTBU14) 1,000 shares / contract Pair 3 (TRUE - TRUEU14) 1,000 shares / contract Training : 600 Execute : 300 Training : 300 Execute : 60 Training : 600 Execute : 300 Training : 300 Execute : 60 Training : 600 Execute : 300 Training : 300 Execute : 60 Traditional Pair Trading No. of Transactions 36 60 40 46 46 34 Gross Profit 1,280 1,820 1,790 1,770 1,535 1,257 Transaction Cost 504 840 1,496 1,720 1,659 1,226 Net Profit 776 980 294 50 (-124) 31 Result for length of training period = 300 and length of execute period = 60 is as follows. For pair 1 of S50U14 - S50Z14, the original TVECM pair trading strategy also generates the best result of 2,972 THB of net profit for trading 1 contract at a time. For pair 2 of KTB - KTBU14, the adjusted TVECM pair trading strategy also generates the best result of 2,092 THB of net profit for trading 1 contract at a time. For pair 3 of TRUE - TRUEU14, the adjusted TVECM pair trading strategy also generates the best result of 912 THB of net profit for trading 1 contract at a time.
  37. 37. 2014 Capital Market Research Institute, The Stock Exchange of Thailand Chapter 6 Conclusion This study examines the long-run relationship, short-run dynamic and threshold cointegration behavior of pairs of assets in Thailand’s Stock Spot and Futures Market. The arbitrage opportunities among the markets are assessed from performing a portfolio simulation of a statistical arbitrage strategy called, “Pair Trading Strategy” (a.k.a “Market Neutral Strategy”). Three pairs of assets, “S50U14&S50Z14” – “KTB&KTBU14” – “TRUE&TRUEU14”, are selected to studied using 5-minute price data between 2nd July, 2014 to 29th August, 2014 which include 40 trading days or 2,439 observations for each pair. The result shows that each pair has long-run relationship. With existence of transaction cost (e.g. Commission Cost, value-added tax), threshold behavior is considered to be existing. Threshold Vector Error Correction Model (TVECM) is applied to estimate the thresholds parameter. A previous study of Songyoo (2013) proposed a pair trading strategy which applies thresholds parameter from TVECM. This study adjusts the strategy and measures the performance by net profit of the simulated portfolios and comparing results to the traditional pair trading strategy which use standard deviation as trigger point. The result shows that arbitrage opportunities exist in the markets for the proprietary trader using the pair trading strategy applying TVECM’s threshold parameters as signal trigger. The performance of the original TVECM pair trading strategy and another adjusted version are superior to the traditional pair trading strategy. Difference in length of training period and
  38. 38. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 34 execute period make the result of each strategy vary. Minus return found in original TVECM strategy, whereas the adjusted TVECM strategy still create a positive return. This would be a sign of more robustness in adjusted TVECM strategy. Anyway, the limited numbers of studied pairs is insufficient to decide the best strategy. This study limits the size of portfolio to trade only one contract at a time. To trade more than one contract, the liquidity of the asset will be a major issue to be concerned. Anyway, we estimate a maximum potential return for each pair by calculation of average trading volume per period and then multiply it with return for one contract. As a result, we have maximum potential return of each pair in descending order as “S50U14&S50Z14” (THB 216,956) , “TRUE&TRUEU14” (THB 203,615) and “KTB&KTBU14” (THB 138,072).
  39. 39. 2014 Capital Market Research Institute, The Stock Exchange of Thailand References Avellaneda, M., & Lee, J. H. (2010). Statistical arbitrage in the US equities market. Quantitative Finance, 10(7), 761-782. Balke, N. S., & Fomby, T. B. (1997). Threshold cointegration. International economic review, 627-645. Dickey, D. A., & Fuller, W. A. (1981). Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica: Journal of the Econometric Society, 1057-1072. Engle, R. F., & Granger, C. W. (1987). Co-integration and error correction: representation, estimation, and testing. Econometrica: journal of the Econometric Society, 251-276. Fama, E. F. (1965). The behavior of stock-market prices. Journal of business, 34-105. Fama, E. F. (1970). Efficient capital markets: A review of theory and empirical work*. The journal of Finance, 25(2), 383-417. Gatev, E., Goetzmann, W. N., & Rouwenhorst, K. G. (2006). Pairs trading: Performance of a relative-value arbitrage rule. Review of Financial Studies, 19(3), 797-827. Granger, C. W. (1981). Some properties of time series data and their use in econometric model specification. Journal of econometrics, 16(1), 121-130. Hansen, B. E., & Seo, B. (2002). Testing for two-regime threshold cointegration in vector error- correction models. Journal of econometrics, 110(2), 293-318. Johansen, S. (1991). Estimation and hypothesis testing of cointegration vectors in Gaussian vector autoregressive models. Econometrica: Journal of the Econometric Society, 1551-1580. Kaewmongkolsri, C. (2011). Lead-lag Relationship and Price Discovery in KTB Spot and KTB Futures Markets. Faculty of Commerce and Accountancy, Thammasat University. Nestorovski, M., Naumoski, A. (2013). Economic Crisis and the Equity Risk Premium. 9th International ASECU Conference on "Systemic Economic Crisis: Current Issues and Perspectives". Songyoo, K. (2013). Optimal Positioning in Thailand's Spot and Futures Markets: Arbitrage Signaling from Threshold Cointegration Model (Dissertation, Thammasat University).
  40. 40. 2014 Capital Market Research Institute, The Stock Exchange of Thailand 36 Thongthip, S. (2010). Lead-lag Relationship and Mispricing in SET50 Index Cash and Futures Markets (Doctoral dissertation, Faculty of Economics, Thammasat University). Vidyamurthy, G. (2004). Pairs Trading: quantitative methods and analysis (Vol. 217). John Wiley & Sons.
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